Suppose a company has some extra cash at the end of year. They consider their options for how to utilize it: They could invest in a new factory or warehouse, hoping that expansion will boost profits; they could send some of the extra cash to investors in the form of dividends; or they could buy back company stock.

What is a stock buyback?

A stock buyback, also known as a share repurchase, happens when a company uses available cash to buy back publicly traded shares. The acquired stock is re-absorbed by the company, reducing the number of shares outstanding. 

Buybacks tend to be welcomed by investors, and share prices often rise after a company announces a buyback program. Repurchases reduce the number of shares outstanding, which means a smaller supply. If demand for the shares remains consistent, the stock often will rise.

Buybacks also tend to improve a company’s price-to-earnings (P/E) ratio, a key valuation measure for investors. The P/E is calculated by dividing annual earnings per share by the number of shares outstanding. With fewer shares outstanding, earnings are spread over a smaller base. The denominator in the ratio (the number of shares), is smaller, so the P/E is too. A lower P/E means the company’s shares are a better value. At the same time, existing shareholders will hold a bigger piece of the company pie as their ownership stake increases.

How stock buybacks work

Stock buybacks are usually initiated by company management after they determine there are no other profitable uses for available cash. The company can purchase the stock on the open market or directly from its shareholders, but it takes board approval to set the process in motion.

Companies put out a press release and make a filing known as an 8-K with the Securities and Exchange Commission (SEC). Share repurchases are usually discretionary, and the company only buys when it deems the price to be acceptable. Once a share repurchase occurs, the company may hold the stock as treasury shares for future use or cancel them. Either way, the result is to reduce the number of shares outstanding, helping to benefit existing shareholders.

Companies that initiate stock buybacks generally do it in one of two ways:

1. Buys at current prices in the open market.

   When managers think the stock price is a good value, they may repurchase stock as they see fit or use a prescheduled approach to buybacks. Often with a buyback announcement, the share price increases because the market views it as a positive sign. The share repurchase is contingent on management’s belief that the shares are worth buying at current prices, and sometimes planned repurchases don’t take place.

2. Offers a fixed price to existing shareholders.

   This is called a tender offer. This occurs when a company offers to buy back shares within a certain time frame, usually for more than the price on the open market. Shareholders decide how many shares they wish to tender at a price they are willing to accept.  

How buybacks affect investors

Here’s an example of what a share repurchase might look like for an investor.

Imagine a company that’s experiencing good growth and profitability, but it believes that its stock price doesn’t reflect the business’s true value. The company may decide to buy back shares at current market prices because it considers them undervalued.

For simplicity's sake, let’s say there are 100,000 shares outstanding. If the company were to buy back 20% of its shares using $200,000 of available cash, the number of outstanding shares would be reduced from 100,000 to 80,000.

Here is how the ownership stake of an investor with 1,000 shares would change based on simple math.

‍Pre-buyback: 1,000 shares divided by 100,000 = 1%. In other words, the investor owned 1% of the company’s shares.

Post-buyback

: 1,000 shares divided by 80,000 = 1.2%. The investor now holds 1.2% of the company’s shares. 

Reasons for a buyback

There are a variety of reasons companies buy back shares. Company management may consider a buyback to increase the stock’s market value. Even though the company may have generated earnings growth, management may believe the stock price doesn’t reflect the business’s fundamental value. 

For other companies, lackluster earnings results, a negative news report, or an adverse economic climate may lead to share valuations that management believes are unjustified.  

Dilution is another popular reason for a company to do a buyback. Stock dilution is often the  result of shares issued through employee stock option plans (ESOP) or 401(k) programs. Either of these tend to increase the number of shares outstanding, diluting the value of other shareholders. These additional shares also affect important financial measures, lowering the earnings-per-share ratio (EPS)—a critical input in the P/E calculation.

A buyback tends to boost EPS and lower the P/E, creating more attractive share valuations.

Benefits of share buybacks for investors

For many investors, buybacks can be a plus; they see it as an effective way to reward shareholders. Because buybacks reduce the supply of shares available for public trading, while also improving key share valuation metrics, they tend to boost a stock’s price. Often, simply the announcement that a company plans to repurchase stock is enough to send share prices higher.

Buybacks also have none of the potential tax liabilities of dividend payments.

Buybacks vs. dividends

Both buybacks and dividends are similar in that they represent a use of corporate cash. But there are important differences:

• Dividends appeal to many shareholders because they represent cash payments that can be used to reinvest or spend. A buyback doesn’t directly put cash into the hands of shareholders.
• Taxes also come into consideration. Shareholders will pay taxes on dividends based on their regular income tax rate, whereas buybacks are not a taxable event.
• Company managers might prefer buybacks to dividends. As big shareholders, they too would receive dividend payments, although taxes would be due. A buyback, however, tends to increase the value of the shares they do hold without creating a tax liability. 

Downsides and effects on the economy

Stock buybacks are often criticized by those who see them as gimmicks that do nothing for economic growth. Among their arguments they raise:

• Companies use buybacks to produce temporarily higher stock prices instead of investing to increase long-term profitability.
• When large companies buy back shares, corporate executives can be among the greatest beneficiaries because they often own a lot of stock. In other words, it’s a backdoor way to increase executive pay, which critics say is already too high.
• A buyback financed with debt is risky. The added debt can threaten the company’s credit rating and repaying the debt reduces profitability. 
• Some investors prefer dividends over buybacks even with the tax implications. They can control how to use their dividend cash where they like.

Alternatives to buybacks

When it comes to increasing shareholder value, buying back stock represents only one way companies can use available cash. The following are other uses of capital: 

• Dividend payments are a direct cash reward to investors, but they carry a tax liability and shareholders will pay tax at the same rate as they do on their regular income.
• Extra money may be used to purchase other securities, such as what are known as callable bonds, which are sold with a provision for repurchase before they mature.
• Research and development (R&D) is another area where companies invest their money to achieve growth and boost shareholder value.

The bottom line

By shrinking the number of shares outstanding, buybacks often lift stock valuations for shareholders in the short term. While the process improves financial ratios that can favor the company and the investor, it’s important to remember that the company used money that potentially could have been used in other ways.

The main concern for investors is not necessarily whether a stock buyback is good or bad but rather is the company generating a good return on their investment.